What Blows Up First? Part 4: China

To Westerners, China has always been a mystery. The huge population of very
smart, hard-working people. The succession of unfamiliar, authoritarian governments.
The sense that they're playing the long game while we're obsessed with quarterly
reports - and that they're laughing at our naiveté and lack of historical
sense. We don't get the Chinese, but we've always been impressed with them.

Never was this more true than in the past decade. While the developed world
flailed around, trying to figure out how to pay its bills now that new debt
no longer automatically translates into new paper wealth, China seemed to be
the country that got it right. A dictatorship, sure, but a capitalist dictatorship,
ordering its citizens around in the cause of economic development. Their numbers
might be unverifiable, but one couldn't deny the reality of all those skyscrapers
and roads and power plants.

But now it turns out that China was behaving just like us, albeit more secretively,
borrowing like crazy and investing more-or-less randomly. And, like us, they're
discovering that randomly investing other people's money carries some risks.
Two long articles that cover China's plight in some detail were recently posted
by Mike
Shedlock and Automatic
Earth.

In the meantime, here's the short version:

In 2008, when the West - the biggest market for Chinese goods - appeared to
be imploding, China began using its vast foreign exchange reserves and borrowing
power to build truly amazing numbers of skyscrapers, roads and airports, among
many other things. At the same time, it encouraged the creation of a "shadow
banking system" of local/regional development agencies and investment funds
that could borrow and lend more-or-less off the books. The result of this stealth
QE was even more new debt than the U.S., Europe and Japan were taking on, something
like $15 trillion in five years.

Now a growing part of that debt is going bad and China is not sure how to
fix it. They're bailing out some of the more serious insolvencies while trying
to rein in the shadow banking sector. But it's not working. Bank lending soared
in January, even while the list of potential problem borrowers lengthened.
Apparently the coal companies are in especially bad shape.

So what does this mean for the rest of us? Since China was thought (rightly,
as it turned out) to be one of the engines pulling the global financial system
back from the abyss, how would a financial crisis there affect, say, the S&P
500 and Treasury bonds? The logical answer is that "risk on" would switch to "risk
off" overnight, sending stocks down and Treasuries, as the last financial safe
haven, way up.

Precious metals are a trickier call. China has been a huge buyer of gold,
so presumably a crisis would lead it to buy less. On the other hand, if safe
havens are back in style, then a suddenly-terrified world might more than make
up for China's lower demand. Gold certainly looks better than growth stocks
for the early part of such a crisis.

And then, of course, there's the question of how the Fed, ECB and Bank of
Japan will react to China's problems spreading to the developing world. Almost
certainly they'll double down on their current debt monetization policy (or
in the case of the ECB, join that party). In the past this has sent the leveraged
speculating community back into "risk on" -- which is why the world is in the
current mess.

Someday, the markets will see such policies as the acts of desperation that
they clearly are. This might be that time, or it might not. We'll only know
in retrospect.

John Rubino edits DollarCollapse.com and has authored or co-authored five
books, including The Money Bubble: What To Do Before It Pops, Clean
Money: Picking Winners in the Green Tech Boom, The Collapse of the Dollar
and How to Profit From It, and How to Profit from the Coming Real Estate
Bust. After earning a Finance MBA from New York University, he spent the
1980s on Wall Street, as a currency trader, equity analyst and junk bond analyst.
During the 1990s he was a featured columnist with TheStreet.com and a frequent
contributor to Individual Investor, Online Investor, and Consumers Digest,
among many other publications. He now writes for CFA Magazine.